The Long-Term Value of Internet Companies

A decade after the last technology bubble burst, the signs are everywhere that it is happening again.

Look at what’s happened to the highly publicized initial public offerings: Facebook’s value has declined $30 billion since its I.P.O., costing investors nearly half their investment. Zynga shares have plummeted. Groupon shares trade at such an extreme discount that there should be a Groupon for them. Pandora’s stock, once $17, has touched $7. Companies like Friendster and MySpace, meanwhile, toil in oblivion.

These declines didn’t have to occur. Creating new markets is a messy, fast-moving process in which many companies will collapse. Instead of mourning Facebook’s inability to surpass the market capitalization of General Electric, we should be celebrating the success of companies that have navigated early-stage minefields.

An aggressive approach to early-stage venture investing has led to a bubble in start-up financing. Financial analysts of these growth companies make a host of assumptions to project performance to justify outsize valuations.

As a consequence, promising young companies like Groupon and Zynga get overvalued. To support its I.P.O. valuation of nearly 100 times its earnings, Facebook would have to sustain an unrealistic growth rate. Even at its lower valuation, Facebook’s market capitalization is 12 times its revenue. Last week, Facebook reported respectable growth across all its important metrics: new users, active users, total advertising revenue and operating income. Yet, the vicissitudes of volatile markets caused its stock to decline 12 percent after its earnings announcement.

In a prudent financing environment, investors would be banking on Facebook’s future instead of wondering why it had lost so much of its I.P.O. value. Critics have argued that Facebook’s backers increased value for the company’s original investors by aiming for the highest valuation during the I.P.O. Did they lose sight of the importance of creating long-term value by having a base of stable committed shareholders who understand the business and are focused on its long-term success?

As we learned during the financial crisis, speculative traders looking for outsize returns can increase the volatility of company valuations. In turn, management gets trapped into trying to justify excessive valuations by focusing on short-term results. These huge swings in valuation have consequences. They jeopardize acquisitions. They demoralize employees who are compensated with stock. Most important, they distract senior leaders from their real job: creating great products that serve their customers.

Entrepreneurs who want to build for the long term should avoid going public until they have positioned themselves as market leaders with diverse and stable revenue streams. Even then, they shouldn’t strive to notch 80 times price-to-earnings ratios or a 100 percent pop in its shares on the first day of trading. Google is a classic example of the right way to go public. It delayed going public until six years after its founding. Since its I.P.O. in 2004, Google stock has moved steadily upward, rewarding its investors with a 500 percent return. Google’s $200 billion market capitalization is justified by $40 billion in revenue and $10 billion of net earnings.

Rather than trying to maximize the value of their I.P.O.’s, start-ups should align themselves with capital partners who are builders themselves, interested in sustainable growth and wary of unrealistic valuations. They should select board members committed to the long-term success of the company, compensating their directors with restricted stock. Founders should accept lower valuations in order to attract the right investors – financial partners who will invest in the brand, research and development and operational engine to create sustainable competitive advantage.

The striking example of Warren E. Buffett contrasts markedly with what we observe happening with the social media start-ups. Mr. Buffett cautions his investors about overpaying for assets and often talks down expectations for Berkshire Hathaway stock. He has taken the high road in treating his shareholders like long-term business partners. While shareholders don’t get one-time pops, they have compounded earnings at more than 20 percent a year for 50 years.

These days, the scrutiny of public company leaders is intense, and public markets are unforgiving. The high turnover in hedge fund portfolios makes Wall Street a place where fortunes are made, not where businesses are built.

In contrast, the best entrepreneurs are business builders. They should keep a laserlike focus on precisely that and never deviate to please short-term traders.